There are two articles of faith in securities regulation concerning public disclosure of information. The first is that disclosure will level the playing field by reducing knowledge asymmetries. The second is that disclosure allows conflicts of interest to be managed instead of simply forbidden.
Underneath all this is a crucial assumption. We assume that if disclosure is thorough enough, plainly-worded enough and sufficiently timely, then investors can and will use the information effectively to assess risks and to make rational investment decisions in their own best interests. But what if that assumption is wrong? What if retail investors actually don’t have the ability to use disclosure effectively? What if, in fact, disclosure sometimes causes investors to act contrary to their interests?
These are the types of questions that behavioural researchers such as Yale University’s Daylian Cain, Harvard University’s Sunita Sah and Carnegie Mellon University’s George Loewenstein are asking — and their findings indicate that disclosure doesn’t always do what we expect.
For starters, the experiments these researchers and others have conducted show that people generally don’t discount advice from biased advisors as much as they should, even when the advisors’ conflicts of interest are disclosed. The more startling findings, however, are that disclosure can have a variety of perverse effects:
- It can increase the bias of the advice because it leads advisors to feel a sense of moral license. (e.g., the advisor thinks: “I’ve disclosed my bias, so I don’t need to be even-handed.”)
- It also may cause investors to feel comfortable when they should be wary. (e.g., the investor thinks: “My advisor was so upfront and honest about that conflict of interest. I feel I can really trust her now.”)
- And through something known as the ‘panhandler effect’ (in which many people will just give in to a request rather than say “No”), disclosure can increase the tendency of investors to comply with biased advice even though their trust in the advice has been diminished.
No one should suggest this research is definitive. It’s still emerging, still relatively new and in a formative stage. But if these observations on human behaviour have any validity, the implications for securities regulation are profound.
How, for example, do we keep our conflict-prone markets functioning efficiently if intermediaries can’t manage those conflicts through disclosure? Must we ban conflicted advice altogether? And for advocates who call for further and better disclosure, what’s the point if investors are hardwired to disregard it or to use it inappropriately?
These implications won’t just go away, and we can’t simply ignore something that casts doubt on the soundness of our key assumptions. Lots of positions may have to be re-thought on a number of fronts — but the first step surely is to investigate this further.
We need testing to determine whether these same behavioural phenomena affect not only disclosure of conflicts but also risk disclosure, and, if so, to what degree. This should be made a priority given the push that’s on right now for expanded access to prospectus-exempt investments. As part of that initiative, Canadian regulators are proposing to protect investors by having them sign risk acknowledgement forms, yet no testing appears to have been done on the efficacy of that as a warning device.
The devil’s in the details here. We need to find out what kind of wording actually works, and what doesn’t. We also need to see whether the timing of risk presentation and acknowledgement has an impact. Is the disclosure effective when presented at the outset and before a purchase decision has been made, but ineffective afterward? If it’s left to the end, is it too easily perceived as mere boilerplate inserted by overcautious lawyers?
It’s tempting to think this can all be dealt with just by applying a bit of common sense: spell the risks out in plain language on a piece of paper, ensure investors read and sign it, and everything’s fine — they now know what they’re getting into. However, behavioural research tells us it’s not that simple, nor is today’s disclosure environment simple. Complex investment products, many of them truly difficult to understand, are showing up everywhere in the retail market while hordes of unsophisticated investors are effectively being driven into the market by low yields on simple products such as guaranteed investment certificates and Canada Savings Bonds.
In this environment, we shouldn’t just plow ahead with reforms based on old assumptions. We’ve been warned those assumptions may be wrong. Let’s not ignore the warning. Let’s find out what actually works.